Image by Mike Luckovich, editorial cartoonist and The Atlanta Journal-Constitution’s Pulitzer Prize winner
Using a 401(k) loan to pay for things may be OK in some instances. However it’s not always a good idea, as stated in an article entitled, “Think Twice Before Taking Out a 401(k) Loan,” written by one of my favorite bloggers Andy Prescott. Andy is a CPA who writes about saving money at artofbeingcheap.com and is also a staff contributor for HowardClark.com. I enjoyed Andy’s article and, as usual, he brought up a few good points from a CPA perspective.
Then I thought about this. Since I’m a bankruptcy attorney, why not explain how this works based on my experience and training? Helping debtors make good choices when faced with financial problems is my business.
For quite some time now, as a general word of advice in most circumstances, I advise most clients that taking out a 401(k) retirement account loan to pay off pressing debt is probably not your best option. Of course this depends. Everyone’s situation is different. Even so, especially when a person is considering bankruptcy, taking a 401(k) loan to pay off debt just complicates the whole idea of using this viable option for relief. Not only does this complicate good decision making, it also complicates a bankruptcy discharge, trustee decisions and more.
Say the bills are mounting. You are having trouble paying them. Maybe you lost your job, or had an unexpected death in the family, an unusual medical issue or recently became unemployed. Whatever the reason, bankruptcy may seem like an awesome option. Bankruptcy is a useful legal tool. Bankruptcy is intended to help debtors in need get a fresh start. A fresh start sounds like a really good thing, right? Well, it depends.
Often, a truly fresh start depends on the decisions a debtor makes pre-bankruptcy filing, like using a 401(k) or other retirement account loan to pay down debt. Under current federal and local bankruptcy rules, in a Chapter 7 or Chapter 13 bankruptcy case, an ERISA qualified retirement account is a protected asset. This includes a 401(k) savings plan and most ERISA qualified retirement accounts, like IRAs, including Roth IRAs. These types of accounts are exempt from creditors claims. Great! This is the good news! A 401(k) is a protected exemption.
Now for the bad news. Suppose a debtor gets into financial trouble. The debtor is stressed and needs fast easy cash to payoff bills, maybe some medical bills or old IRS debt, maybe even the mortgage payments. To a debtor under stress, borrowing against a 401(k) and using those funds to pay down debt seems to make sense. It’s easy. No credit checks required, no questions asked and there is very little paperwork. Ask and ye shall receive, the bills can be paid. But wait!
Little did our friend the debtor realize, that if bankruptcy was ever a good option, they may have spoiled a new beginning. Borrowing against a 401(k) retirement account to pay down debt, prior to filing, will seriously jeopardize their fresh start. After all, when faced with serious financial struggles, bankruptcy should be a viable option. It’s the new alternative to the old debtor’s prison. Anyway, depending upon the circumstances bankruptcy is useful, but not if the option is compromised by poor planning and decision-making.
As a general rule, a 401(k) retirement account loan can’t be discharged under Bankruptcy. If you borrow against it, then file for bankruptcy, you have to pay the loan back according to your 401(k) retirement account plan rules. What’s done is done. There’s no going back.
On the other hand, say a debtor facing big financial trouble decides not to pay down bills by borrowing against a 401(k) or other ERISA qualified retirement account, then they find a good attorney and decide that bankruptcy is the best option, they have a great opportunity for a brand new fresh start.
If all goes well, a debtor may decide to file for bankruptcy under this set of circumstances. The debtor will get to discharge most, if not all, insurmountable bills (most debts are forgiven under chapter 7) or pay for a short time with a reasonable payment plan and then get a full discharge (under a chapter 13). Additionally, the debtor gets to keep all their 401(k) retirement savings! Like magic, they get a fresh start. Presto-chango!
Like I said before, bankruptcy is often a useful tool for those who need it. Making wise decisions about 401(k) retirement savings accounts and other qualified ERISA retirement accounts is important. These kinds of accounts are often overlooked valuable exempt (protected) assets under state and federal bankruptcy law.
This is one reason why it’s a good idea to think of your finances like a critically important lifetime project. “Measure twice and cut once.” Think twice, in other words, before making big financial decisions or taking out 401(k) retirement account loans to pay debt.
Speak to your trusted attorney. Get all the facts. Plan your best course of action so your action doesn’t plan you.
Got it? Got it. Good!
ABOUT ME: Attorney Kelly is an attorney in good standing, licensed to practice in both the Federal District and State Courts of Massachusetts and Rhode Island. Her law practice is focused on consumer finance and bankruptcy. However, Attorney Kelly is experienced in both criminal and civil trial work. On a personal note, Attorney Kelly enjoys writing and other things, like conservation and agriculture. To find out more visit, www.attorneykelly.squarespace.com or http://www.attorneykelly.wordpress.com, or call us at (508) 784-1444.
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